Corporate Finance: Core Principles & Apps, 5e (Ross)
Chapter 12 Risk, Cost of Capital, and Valuation
1) The discount rate for a project should equal the
A) cost of equity of the firm.
B) expected return on a financial asset of comparable risk.
C) discount rate used on the firm’s last profitable project.
D) firm’s weighted average cost of capital.
E) market rate of return.
2) Assume an all-equity company is considering expanding its current operations by increasing the
size of its warehouse. The discount rate used for this project should be the
A) market rate of return.
B) company’s cost of equity capital.
C) discount rate used when the company expanded into a new high-risk product line.
D) lowest discount rate the company assigned to any project over the past 2 years.
E) company’s cost of debt.
3) When the CAPM is used to estimate the cost of equity capital, the expected excess market return
is equal to
A) the return on the stock minus the risk-free rate.
B) the difference between the return on the market and the risk-free rate.
C) beta times the market risk premium.
D) beta times the risk-free rate.
E) the market rate of return.
4) If you assume beta is greater than 1, then which of these will increase the cost of equity capital
according to CAPM?
I. Increase in the risk-free rate
II. Decrease in the risk-free rate
III. Increase in the market rate of return
IV. Decrease in the market rate of return
A) III only
B) I and III only
C) I and IV only
D) II and IV only
E) II and III only
5) Which one of these statements is true?
A) The betas used in the CAPM must be greater than 1 but less than 2.
B) By convention, the market is given a beta of zero.
C) There is zero chance of default on a U.S. Treasury bill.
D) A U.S. Treasury bill has a beta of zero.
E) The rate of return on a U.S. Treasury bill is used as the value of RM in the CAPM.
6) Although a definitive value cannot be determined, which one of these values is considered to be
the best estimate of the market’s historical risk premium according to your textbook authors?
A) 7 percent
B) 5 percent
C) 9 percent
D) 11 percent
E) 15 percent
7) Which one of these will produce an acceptable estimate of the value of the market risk
premium?
A) Historical rate of return on a market index
B) Average rate of return on the S&P 500 plus the risk-free rate
C) Dividend yield of the S&P 500 + Consensus forecast of future dividend growth – U.S. Treasury
bill rate
D) Total dividends paid by the S&P 500 firms for a 1-year period divided by the U.S. Treasury bill
rate
E) Rate computed using the CAPM and a beta of 1
8) The beta of a security provides an estimate of the
A) characteristic line for the security.
B) slope of the capital market line.
C) slope of the security market line.
D) the market risk premium.
E) total risk of the individual security.
9) To calculate beta, you divide the ________ of the stock with the market portfolio by the
________ of the market portfolio.
A) covariance; variance
B) variance; covariance
C) standard deviation; variance
D) expected return; variance
E) covariance; standard deviation
10) If you have returns on a security and also on the market, you can estimate beta using
A) the capital asset pricing model.
B) the dividend discount model.
C) standard deviation.
D) variance.
E) regression analysis.
11) Which one of these is represented by the slope of the characteristic line?
A) Market beta
B) Market variance
C) Security risk premium
D) Security beta
E) Market risk premium
12) Which one of these statements related to beta is correct?
A) The beta of a risk-free security is set at 1.
B) The higher the beta, the lower the risk of a security.
C) Beta measures the risk of a single security if held in a large, diversified portfolio.
D) Beta measures the total risk of a single security whether held independently or as part of a
portfolio.
E) A stock with a high standard deviation will also have a high beta.
13) Assume each firm within an industry has similar operations and financial structures as the
industry as a whole. Which one of these statements related to beta is correct given this assumption?
A) Industry betas are less reliable than firm betas.
B) Firms should always use their own betas rather than the industry beta.
C) A change in a company’s use of financial leverage has no effect on the company’s beta.
D) The error in beta estimation for a single security exceeds the error for a portfolio of securities.
E) All firms in the industry will have the same beta.
14) Beta values are highly dependent on the
A) direction of the market movement.
B) overall cycle of the market.
C) variance of the market and asset, but not their comovement.
D) covariance of a security with the market.
E) market risk premium.
15) Which one of these statements related to beta is correct?
A) A firm with a given sales cyclicality can reduce its beta by replacing variable production costs
with fixed costs.
B) The beta of debt is generally assumed to equal the market beta.
C) Highly cyclical stocks tend to have low betas.
D) The levered beta of equity exceeds the asset beta.
E) Stocks with a high variance must have a high beta.
16) The use of debt is called
A) financial leverage.
B) production leverage.
C) operating leverage.
D) total asset turnover risk.
E) business risk.
17) Companies A and B are identical except for their capital structures. Company A is an
all-equity company while Company B is levered. Given this, you can assume that Company B’s
equity beta is ________ Company A’s beta and its debt beta is assumed to be ________.
A) greater than; equal to zero
B) greater than; equal to one
C) equal to; equal to the market beta
D) less than: equal to zero
E) less than; equal to one
18) The asset beta is defined as the beta of
A) a fully diversified portfolio.
B) an undiversified portfolio.
C) the common stock of a levered firm.
D) a risk-free security.
E) the common stock of an unlevered firm.
19) The beta of a firm is more likely to be high under which two conditions?
A) High cyclical business activity and high operating leverage
B) High cyclical business activity and low operating leverage
C) Low cyclical business activity and low financial leverage
D) Low cyclical business activity and low operating leverage
E) Low operating and financial leverage
20) Which one of these statements is correct?
A) The asset beta will equal the equity beta for a levered firm.
B) Leverage increases the asset beta.
C) A portfolio beta is the summation of the betas of each of the individual securities held in the
portfolio.
D) The equity beta refers to the beta of an all-equity firm.
E) Financial leverage refers to a firm’s use of debt and its related fixed costs of finance.
21) Which of these are determinants of beta?
I. Financial leverage
II. Cyclicality of revenues
III. State of the economy
IV. Operating leverage
A) I and IV only
B) II and III only
C) I, III, and IV only
D) I, II, and IV only
E) II, III, and IV only
22) A firm with high operating leverage is best defined as a firm that has
A) a high debt-to-equity ratio.
B) high fixed costs relative to variable costs.
C) a low, relatively stable beta.
D) high variable costs relative to fixed costs.
E) a high sales/assets ratio.
23) Which one of these formulas will provide an estimate of the growth rate of a security’s
dividends?
A) Beta × Return on equity
B) Retention ratio × Weighted average cost of capital
C) Retention ratio × Return on equity
D) Beta × Return on assets
E) Retention ratio × Return on assets
24) Which one of these statements is correct?
A) ROE as used in the estimation of g is defined as a firm’s earnings divided by the market value of
its equity.
B) The DDM requires a short-term estimate of dividend growth.
C) Academics generally prefer the DDM over the CAPM.
D) The DDM seems to have more estimation error than the CAPM.
E) Measurement error in the estimate of the growth rate of dividends increases as you move from a
single security to the overall market.
25) Which of the following are the two primary advantages of CAPM?
I. Simplicity
II. Absence of estimation error
III. Applicability to both dividend and nondividend paying firms
IV. Explicit adjustment for risk
A) I and II
B) II and III
C) I and III
D) III and IV
E) I and IV
26) The use of WACC as the discount rate when evaluating a project is acceptable when the
A) company is well established and financially stable.
B) WACC produces a positive NPV.
C) risk of the project is equal to the company’s overall level of risk.
D) company is well diversified and the unsystematic risk is negligible.
E) project has only systematic risk.
27) Diversified Industries is a multiproduct company operating in a number of industries. Assume
the company is analyzing a new project that has risks unrelated to those of the current company’s
products. When computing the net present value of the new project the cash flows should be
discounted using
A) a rate based on a beta of one since the company is well diversified.
B) a rate based on the company’s current beta.
C) the risk-free rate of return.
D) the market rate of return.
E) a rate commensurate with the risk level of the project.
28) Which of these may occur if a company uses its overall cost of capital as the discount rate for
all projects?
I. Profitable low-risk projects may be incorrectly rejected.
II. Only projects with risks similar to the current company will be accepted.
III. Too many high-risk projects may be accepted.
IV. Only low-risk projects will be accepted.
A) II only
B) II and IV only
C) I and III only
D) I and IV only
E) I, II, and III only
29) Alto Music is a levered company providing musical instruments and supplies through its retail
outlets. The company is considering expanding into art supplies. Since this is an entirely new
venture, the company should
A) use the current company beta when computing the required risk premium for the project.
B) use the market beta when computing the project’s discount rate.
C) increase the project’s initial cost by a factor of (1 + Company β) to offset the increased risk.
D) use the company’s cost of equity as the project’s discount rate.
E) use the pure play approach to assign a discount rate to the project.
30) In a changing interest rate environment, the cost of new debt
A) is assumed to be zero for a levered firm.
B) is equal to the embedded cost of old debt.
C) generally exceeds the cost of equity on a pretax basis.
D) is equal to the cost of borrowing.
E) increases when taxes are considered.
31) A company’s cost of debt will decrease when
A) market interest rates increase.
B) the coupon rate on the company’s bonds increase.
C) tax rates increase.
D) inflation rates increase.
E) interest is paid semiannually versus annually.
32) The cost of preferred stock
A) increases as the beta of the firm increases.
B) is equal to the annual dividend divided by the par value of the stock.
C) is equal to the annual dividend divided by the present value of all the future dividend payments.
D) varies as tax rates vary.
E) is generally computed using the CAPM.
33) Assume a company’s cost of equity exceeds its pretax cost of debt. Given this assumption and
assuming all else is held constant, the company’s WACC must increase if the
A) tax rate decreases.
B) company’s beta decreases.
C) pretax cost of debt decreases.
D) debt-to-equity ratio decreases.
E) market risk premium decreases.
34) If a company is all-equity financed, its WACC will equal
A) RF.
B) βRF.
C) βRS.
D) RS.
E) RM.
35) When computing the weights to be used in a project’s WACC equation, you should use the
A) proportions of debt and equity that will finance the project.
B) current market values of debt and equity.
C) average market weights of debt and equity that are expected over the project’s life.
D) average book weights of debt and equity that are expected over the project’s life.
E) current book values of debt and equity.
36) Why is an accurate WACC so important when evaluating a new project? Assume a negative
cash outflow at Time 0 and positive project cash flows thereafter.
A) The coupon rate on new bonds issued to fund the project will be set equal to WACC.
B) The project’s WACC will replace the firm’s WACC as the discount rate for all future projects.
C) The project’s accept/reject decision will be based on the NPV calculated using that WACC.
D) The return to shareholders will be limited by the WACC.
E) The firm can only maintain or increase its current value if the project WACC exceeds the
project’s internal rate of return.
37) How does the valuation of a company vary from the valuation of a project using WACC?
A) Book values are used as the weights for WACC when valuing a company.
B) Debt and equity weights are set equal for WACC when valuing a company.
C) A terminal value is included in the valuation process for a company but generally not for a
project.
D) Debt is not adjusted for taxes when computing the WACC for a company valuation.
E) The WACC must be set equal to RM when valuing a company.
38) The terminal value of a company is based on which one of these assumptions?
A) The growth rate of the future cash flows will exceed the company’s WACC.
B) All future cash flows will be constant.
C) The cash flows after Time T will diminish on an annual basis.
D) The cash flows will increase in the future at a constant perpetual rate.
E) The company will be sold at Time T for the stated terminal value.
39) Which one of these is a commonly used multiple for overall company valuation?
A) D/E
B) EV/EBITDA
C) P/E
D) Price/Book
E) Sales/Assets
40) In project analysis, flotation costs are generally
A) included as a final cost of the project.
B) included in the cost of capital.
C) treated as an additional tax.
D) treated as a cost of debt.
E) included in the amount raised.
41) The weights used in the computation of a project’s flotation costs should be based on the
A) market values of the company’s outstanding debt and equity.
B) current book value of the company’s debt and equity.
C) company’s historical debt-to-equity ratio.
D) the company’s target debt-to-equity ratio.
E) project’s actual sources of funding.
42) What value should you assign as the flotation cost of internally generated equity financing?
A) A cost that yields the company’s required rate of return on the funds utilized
B) Fifty percent of the external flotation cost of equity
C) A cost of zero
D) The same cost as that of the external equity financing
E) The same cost as that of the debt financing
43) Assume the S&P 500 has a dividend yield of 3.2 percent. Analysts expect overall dividends to
grow at 5.4 percent annually. Treasury bills yield 2.1 percent. The expected market rate of return is
________ percent, and the market risk premium is ________ percent.
A) 10.7; 1.1
B) 10.7; 6.5
C) 8.6; 6.5
D) 8.6; 1.1
E) 5.3; 1.1
44) ABC stock has a beta that is 13 percent higher than the overall market beta. The risk-free rate is
3.1 percent, and the market rate of return is 10.6 percent. What is the company’s cost of equity?
A) 12.27%
B) 10.91%
C) 11.58%
D) 15.48%
E) 16.08%
45) The cost of equity for Ryan Corporation is 17 percent. The expected return on the market is
12.94 percent, the risk-free rate is 3.5 percent, and the tax rate is 34 percent. What is the company’s
equity beta?
A) 0.97
B) 1.62
C) 1.18
D) 1.07
E) 1.43
46) Assume the overall market has a risk premium of 7.1 percent, and the risk-free rate is 2.9
percent. What is the risk premium for a stock that has a beta of 0.94 and a standard deviation of
12.7 percent?
A) 5.62%
B) 6.67%
C) 7.29%
D) 5.58%
E) 6.82%
47) Whitehall Camps recently paid its annual dividend of $1.42 a share. These dividends have
been increasing by 2.2 percent each year and are expected to continue this trend. What is the cost
of equity if the stock sells for $22.89 a share?
A) 8.54%
B) 9.38%
C) 7.29%
D) 7.58%
E) 6.82%
48) A stock portfolio consists of 27 percent Stock A, 38 percent Stock B, and the remainder is
invested in Stock C. The security betas are 1.09, 0.84, and 1.33 for Stocks A, B, and C,
respectively. What is the portfolio beta?
A) 1.072
B) 1.106
C) 1.079
D) 1.103
E) 1.084
49) A portfolio is invested 40 percent each in Stock L with a beta of 1.48 and Stock K with a beta
of 1.05. The remainder of the portfolio is invested in secured debt. What is the portfolio beta?
A) 1.018
B) 1.012
C) 1.033
D) 1.101
E) 1.009